EQUITY VALUATION

BY: Sheeza Ashraf

Neelam Afroz
Aamir Khan
Elna V. Rajan
Suaid Mulla
 Equity valuation techniques
1. Balance sheet Technique
i. Book Value
ii. Liquidity Value
iii. Replacement Cost

2. Discounted Cash flow Technique

iv. Dividend Discount model
v. Free Cash flow Model

3. Relative Valuation Technique

vi. Price-earning ratio
vii. Price book value ratio
viii.Price sales ratio
 Balance Sheet valuation
• Book Value
• Liquidation Value
• Replacement Cost
 Book Value
• Net worth of the Company

Paid up equity capital + reserves & surplus

No. of outstanding shares
 Relevance of book value
• Rooted in financial accounting
• Objectivity based on accounting conventions
& policies
• Historical B/S divergent from current
economic value
• Rarely reflect earning power
 Liquidation Value

value realized from Liquidating − amount to be

paid to all creditors & preference shareholders
No. of outstanding equity shares
 Replacement Cost

Replacement cost of : Assets ─ liabilities

Limitations:
Organizational capital not shown on balance
sheet
Critical Analysis of Balance sheet method

Little resemblance to real firm value:

• Assets recorded at historical cost
• Assets such s patents, trade marks, loyal customer,
talented managers do not appear on balance sheet
Focus should be on expected future
• Dividends
• Earnings
• Cash flows
Dividend Discount Model(DDM)
 The value of the equity share is equal to the
present value of the dividend expected plus
the present value of the sales price expected
when the equity share is sold.
 Assumptions for applying DDM:
• Dividends are paid annually
• The first dividend is received one year after
the equity share is bought
Single-period DDM:

D1 P1 D1  P1
V0  1
 1

(1  r ) (1  r ) (1  r )1

Where;
V0 = current value of equity share
D1= dividend expected after an year
r = required rate of return
P1 = price of the share expected after an year
Multiple-period DDM:

D1 Dn Pn
V0  1
 n

(1  r ) (1  r ) (1  r ) n

D1 Dn
V0  1
 n

(1  r ) (1  r )

For an indefinite holding period. The PV of future dividend is:

n
Dt Pn
V0   
t 1 (1  r ) t
(1  r ) n


Dt
V0   .
t 1 (1  r )
t
Zero Growth Model:
The dividend per share remains constant year after year.

Stock’s Intrinsic Value = Annual Dividends / Required Rate

of Return

Example—Intrinsic Value of Preferred Stock

• If a preferred share of stock pays dividends of $1.80 per
year, and the required rate of return for the stock is 8%,
then what is its intrinsic value?
• Intrinsic Value of Preferred Stock = $1.80/0.08 = $22.50
Constant Growth Model:

Dividends grow by a specific percentage each year.

d1 = D0 (1+g) = Next Year's Dividend

k = expected rate of return
g = Dividend Growth Rate

Example—Calculating Next Year’s Stock Price Using the Constant-Growth DDM

If a stock pays a $4 dividend this year, and the dividend has been growing 6% annually, then
what will be the price of the stock next year, assuming a required rate of return of 12%?

Next Year’s Stock Price = $4 x 1.06 / (12% - 6%) = 4.24 / 0.06 = $70.67
This Year’s Stock Price = $4 / 0.06 = 66.67
Growth Rate of Stock Price = $70.67 / $66.67 = 1.06 = Dividend Growth Rate
Works best for:
• best suited for firms growing at a rate comparable
to or lower than the nominal growth in the
economy
• have well established dividend payout policies

Limitations of the model:

• The Gordon growth model is a simple and
convenient way of valuing stocks but it is
extremely sensitive to the inputs for the growth
rate. Used incorrectly, it can yield misleading or
even absurd results.
Two Stage Growth Model:
The extraordinary growth will continue for a finite number of years and
thereafter the normal growth rate will prevail indefinitely.

Value of the Stock = PV of Dividends during extraordinary phase + PV

of terminal price
n
Dt Pn
V0   
t 1 (1  r ) t
(1  r ) n
Works best for:
• It is best suited for firms which are in high
growth and expect to maintain that growth
rate for a specific time period, after which the
sources of the high growth are expected to
disappear.
• The model works best for firms that maintain
a policy of paying out most of residual cash
flows – i.e, cash flows left over after debt
payments and reinvestment needs have been
met – as dividends.
Limitations of the model

• The first practical problem is in defining the length of the

extraordinary growth period. Since the growth rate is expected to
decline to a stable level after this period.

• The second problem with this model lies in the assumption that the
growth rate is high during the initial period and is transformed
overnight to a lower stable rate at the end of the period. While
these sudden transformations in growth can happen, it is much
more realistic to assume that the shift from high growth to stable
growth happens gradually over time.

• The focus on dividends in this model can lead to skewed estimates

of value for firms that are not paying out what they can afford in
dividends. In particular, we will under estimate the value of firms
that accumulate cash and pay out too little in dividends.
H model of equity Valuation
Assumptions
• While the current dividend growth rate
, ga, is greater than gn, the normal long
run growth rate, the growth rate
declines linearly for 2H years.
• After 2H years the growth rate
becomes gn.
• At H years the growth rate is exactly
halfway between ga and gn.
 Valuation Equation for H model

Po = Do [(1+gn) + H (ga – gn )] / r-gn

Where ,
• Po = intrinsic value of the share
• Do = current dividend per share
• r = rate of return expected by investors
• gn = normal long – run growth rate
• ga = current above – normal growth rate
• H = one – half of the period during which ga will level
off to gn
Example : The current dividend on an
equity share of International computer
Limited is Rs 3.00. The present growth
rate is 50%. However, this will decline
linearly over a period of 10 years and
then stabilize at 12%. What is the
intrinsic value per share of
International Computers Limited, if
investors require a return of 16% ?
The inputs required for applying H model are :
Do = Rs 3.00
ga = 50 %
H = 5 years
gn = 12%
r = 16%

Po = Do [(1+gn) + H (ga – gn )] / r-gn

Po = 3 [ ( 1.12) + 5( 0.50 - 0.12)] / 0.16 – 0.12

= Rs 226.5
Free Cash Flow to Equity Model
Free cash flow to equity is the cash
flow available to the company’s
shareholders after all operating
expenses, interest, and principal
payments have been paid and
necessary investments in working
capital and fixed capital have been
made. FCFE is the amount that the
company can afford to payout as
dividend.
 Present Value of
Free Cash Flows to Equity

• “Free” cash flows to equity are derived

after operating cash flows have been
adjusted for debt payments (interest
and principal)
• The discount rate used is the firm’s
cost of equity (k) rather than WACC
 Valuation Equation
n
FCFEt
Vj  
t 1 (1  k j ) t

Where:
Vj = Value of the stock of firm j
n = number of periods assumed to be infinite
FCFEt = the firm’s free cash flow in period t
K j = the cost of equity
EARNINGS MULTIPLIER
APPROACH
 P/E ratio or the earnings multiplier approach

• It is an approach to valuation , practiced

widely by investment analysts .
• The value of a stock , under this approach is
P0 = E1 X P0/E1

Where : P0 = estimated price

E1 = estimated earnings per share
P0/E1 = justified price-earnings ratio
 Determinants of the P/E ratio
• The determinants of the P/E ratio can be derived from the dividend discount
model
p0 = D1 / r – g

in this model D1 = E1(1-b) , b stands for the ploughback ratio,

and g = ROE * b

p0 = E1 (1-b) / r-ROE *b

Dividing both the sides by E1 , we get

p0 / E1 = (1-b)/r-ROE*b
• This equation indicates the factors that
determine the P/E ratio
• The dividend payout ratio , (1-b)
• The required rate of return , r
• The expected growth rate , ROE *b
• P/E ratio and plough back ratio
In the equation b appears in the numerator as
well as denominator, the effect of the change
in b on P/E ratio depends on hw ROE
compares with r , an increase in b leads to an
increase in P/E, if ROE is equal to r an increase
in b has no effect on P/E , if ROE is less than r
an increase in b leads to decrease in P/E.
• P/E ratio and interest rate
The required rate of return on equity stocks
reflects interest rate and risk. when interest
rates increase, required rates of return on all
securities, including equity stocks, increase,
pushing security prices downward. when
interest rates fall security prices rise. hence
there is an inverse relationship between P/E
ratio and interest rates.
• P/E ratio and risk
Riskier stocks have higher required rate of return
and hence lower P/E multiples.
• P/E ratio and liquidity
Other things being equal, stocks which are
highly liquid command higher P/E multiples
and stocks which are highly illiquid command
lower P/E multiples.
• Other influences
1. Size of the company – a larger company tends to
command a higher price-earnings multiple
because of greater investor interest in it .
2. Reputation of management – if the management
of the company is reputed for its integrity and
investor – friendliness, its shares are likely to
command a higher price-earnings multiple.
• Emphirical estimation
1. Whitbek and kisor in US ,
2. Obaidullah and kalyani ramachandran
Reasons for not bring successful in selecting the
appropriate stocks to buy or sell are :
• Shift in market taste
• Change in input values
• Firm effects
 Rules of Thumb
• Thumb Rule 1 – the price-earnings multiple for a
share may be equated with the projected growth
rate in earnings.
If the PEG ratio exceeds 1 , the stock is deemed
overvalued, and if the PEG ratio is less than 1 , the
stock is deemed undervalued.
This thumb rule has some merit because the projected
growth rate in earnings is an important determinant
of the price-earnings multiple. However it ignores
the rate of return.
• Thumb rule 2
For the market as a whole,a reasonable price-earnings
multiple would be the inverse of the prime interest rate.
This thumb rule is implicitly based on the assumption that
there is no relationship between the prime interest rate
an the level of corporate earnings. as the prime rate of
interest is driven substantially by the rate of inflation,
which also has an impact on the level of corporate
earnings, the key premise underlying this rule of thumb
is wrong
• Thumb rule 3
For the market as a whole, a reasonable price-earnings
multiple would be the inverse of the real rate of
return required by investors from equity stocks.
This rule of thumb stems from the argument that
equities represent claim over real assets. Hence , a
rupee of equity income represents a rupee of real
income. This means that the value of equity income
is protected in the face of inflation.
Price-Earning Ratio
• The price/earnings ratio (P/E) is the best known of
the investment valuation indicators. The P/E ratio
has its imperfections, but it is nevertheless the most
widely reported and used valuation by investment
professionals and the investing public.
• The average P/E ratio for the broad market has
been around 15
Eg:

• The dollar amount in the numerator is the closing stock

price.
• In the denominator, the EPS figure is calculated by dividing
the company's reported net earnings (income statement) by
the weighted average number of common shares
outstanding (income statement) to obtain the $2.96 EPS
figure.
• The stock (at $67.44) was trading at 22.8-times the
company's basic net earnings of $2.96 per share. This means
that investors would be paying $22.80 for every dollar of
earnings.
 The Price-Cash Flow Ratio
• This metric compares the stock's market price to the
amount of cash flow the company generates on a per-
share basis.
• Companies can manipulate earnings
• Cash-flow is less prone to manipulation
• Cash-flow is important for fundamental valuation and
in credit analysis

Eg:
• The dollar amount in the numerator is the closing
stock price for the share.
• In the denominator, the cash flow per share is
calculated by dividing the reported net cash provided
by operating activities (cash flow statement) by the
weighted average number of common shares
outstanding (income statement) to obtain the $3.55
cash flow per share figure.
• By simply dividing, the equation gives us the
price/cash flow
• The stock (at $67.44) was trading at 19.0-times the
company's cash flow of $3.55 per share.
 The Price-Book Value Ratio
• The book value of a company is the value of a
company's assets expressed on the balance sheet
• Widely used to measure bank values (most bank
assets are liquid (bonds and commercial loans)
• The book value of a company is the value of a
company's assets expressed on the balance sheet. It is
the difference between the balance sheet assets and
balance sheet liabilities and is an estimation of the
value if it were to be liquidated.
Eg:

• In the denominator, the book value per share is

calculated by dividing the reported shareholders'
equity (balance sheet) by the number of common
shares outstanding (balance sheet) to obtain the
$18.90 book value per-share figure.
• Its stock was trading at 3.6-times the company's book
value of $18.90 per share.
 The Price-Book Value Ratio
• Be sure to match the price with either a recent
book value number, or estimate the book value for
the subsequent year
•  A company trading at a low price to book,
particularly when compared to other companies in
its industry, is thought to be undervalued relative
to its share price.
• However, a low price to book could also be an
indication of negative forward looking investor
confidence (e.g. poor earnings projections) or a
disproportionate amount of intangible assets on
the books
 The Price-Sales Ratio
• The P/S ratio measures the price of a company's stock
against its annual sales.
• P/S reflects how many times investors are paying for
every dollar of a company's sales.
• Strong, consistent growth rate is a requirement of a
growth company
• Sales is subject to less manipulation than other
financial data
Eg:

• In the denominator, the sales per share figure is

calculated by dividing the reported net earnings
(income statement) by the weighted average number
of common shares outstanding (income statement) to
obtain the $13.30 sales per share figure.
• The stock (at $67.44) was trading at 5.1-times the
company's sales of $13.30 per share.
• This means that investors would be paying $5.10 for
every dollar of sales.
 The Price-Sales Ratio
• This ratio varies dramatically by industry
• Profit margins also vary by industry
• Relative comparisons using P/S ratio should be
between firms in similar industries